Banking Union: where are we going?

In October 2014 the ECB has published the results of an almost year-long process in which it went through the books of the 130 so-called Euro zone ‘systemic banks’, measured the quality of their balance sheet, and tested their capital position to a mild and a severe economic downturn scenario.

This is a positive development as the examination constitutes the first step of the Single Supervisory Mechanism, where the ECB, rather than the national authorities, is responsible for supervising the banking system. Moreover, it is a clear improvement over previous exercises in terms of transparency and reliability. For example, by adopting standardized rules for evaluating assets and liabilities, the assessment shows discrepancies in the yardstick used by national supervisors when classifying performing and non-performing loans.

The exercise, however, leaves several questions unanswered. For example, it does not examine how the balance sheet of banks will react in response to deflationary pressures similar to those mounting in the Euro area. Deflation may increase private defaults since households’ and firms’ income to debt ratio falls. Nor it takes into consideration a scenario where countries default on their sovereign debt obligations. Banks still hold a disproportionate amount of own sovereign debt and their fate is linked to the health of public finances. The very low risk weight assigned to government debt in the asset quality review exercise makes the banking system intrinsically fragile.

Perhaps more importantly, several large banks (for example, state owned banks in Germany) were not the object of the investigation or part of their assets were extent from the scrutiny, because politicians took them out of the direct central bank responsibility or managed to water down the control.

The markets reacted positively to the testing exercise and the rates banks of peripheral countries paid to borrow declined, as solvency fears abated. When these costs cut will be passed to borrowing firms and households, the hopes for a recovery will be higher.

The ECB is a supervisory entity, and as such indicates banks which might be in trouble, but does not have the power to fix capital shortfalls problems. Even when the Single Resolution Mechanism comes into play in 2016, national governments will still have a lot of responsibilities in the process. As national governments tend to be lax when it comes to fiscal policies, especially at election times, they are likely to be lax in liquidating banks of ''national interest'' and delay the funds needed for bank recapitalization when their fiscal position is weak - see the recent Portuguese Banco Spirito Santo. As with many union wide legislations, the banking union seems a bad compromise between the need to provide a supranational control of the financial system and the reluctance of national governments to give up political power.

National authorities also have a role when implementing Basel III countercyclical capital buffers, which are intended to make banks lend less in booms and more in crunches. The mandate given to prudential authorities, however, is vague and incentives regulatory forbearance. National authorities have been reluctant to enforce corrective measures before it is too late, and this will continue because prudential policies require the support of the Treasury and the Ministry of Finance.

It is important to establish credible institutions with measurable targets. Many central banks adopted a flexible 2% inflation target, which works as a commitment device and makes central banks accountable. Similarly, national prudential authorities could adopt the flexible target of keeping the volatility of the credit and output cycles roughly the same. This would make monitoring as easy.

The asset quality review and the stress testing exercise are only the first steps in a long and winding process toward a banking union. The seeds are goods but the threats to the process have not subsided.